Solvency and liquidity ratios are important tools used to evaluate a business’s financial well-being. Often, the two are employed together to help entrepreneurs make better decisions about their organization’s direction and resource allocation. Potential lenders and investors may also use solvency and liquidity ratios to make decisions about a company.
While these ratios fit together hand-in-glove when determining the ability to service debt, they are independent concepts and not interchangeable. Solvency relates to a company’s long-term financial position, while liquidity relates to short-term cash flow and the business’s ability to pay off short-term debts, typically those due within a year.
Below is your guide to better understanding solvency and liquidity ratios and how each is used to assess a business’s financial stability.
Comparison of solvency versus liquidity
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Applying solvency and liquidity ratios in a business setting
Let’s use some of the liquidity and solvency ratios (from the table above) to gauge the financial health of two hypothetical companies.
ABC Inc. and XYZ Ltd. both operate in the metal pipe and tube manufacturing sector, with the assets and liabilities from their balance sheets shown below.
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Calculating ABC’s and XYZ’s solvency & liquidity ratios
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Interpretation
Based on the ratios computed above, we can draw some conclusions about the financial condition of these two companies.
ABC Inc.
Liquidity: ABC’s current ratio of 3 indicates a high degree of liquidity. Its quick ratio of 2 suggests adequate liquidity even after excluding inventory. For every dollar of current liability, $2 in assets can be quickly converted to cash.
Solvency: ABC’s debt to equity ratio of 3.33 shows that its debt surpasses its equity by over threefold. Its debt to assets ratio of .67 shows that two-thirds of its assets are financed by debt, reflecting that the company is highly leveraged.
Additionally, close to half of ABC’s noncurrent assets comprise intangible assets, such as goodwill and patents. As a result, its ratio of debt to tangible assets is .91 ($50 / $55), meaning over 90% of its tangible assets were financed by borrowing.
Financial health: ABC has a comfortable liquidity position but a dangerously high degree of leverage.
XYZ Ltd.
Liquidity: XYZ’s current ratio of 0.4 indicates an inadequate degree of liquidity. It has only $0.40 in current assets available to cover every $1 of its current liabilities. Its quick ratio of 20% indicates an even more dire liquidity position, with only 20 cents of liquid assets for every $1 of current liabilities.
Solvency: XYZ’s financial leverage appears to be at a comfortable level. Its debt-to-equity ratio of 0.25 and debt-to-asset ratio of 0.13 indicate that the company is at only 25% of equity and that only 13% of its assets are financed by debt.
Further, XYZ’s asset base consists wholly of tangible assets. Its ratio of debt to tangible assets is 13% ($10 /$75), or about one-seventh that of ABC’s 91%.
Financial health: XYZ is in a precarious liquidity position but a comfortable debt position.
Special considerations when using solvency and liquidity ratios
• Use a combination of liquidity and solvency ratios to get a clear picture of a company’s financial health. Using only one set of ratios may provide a misleading picture.
• Solvency and liquidity ratios vary by industry. A comparative analysis of financial ratios for two or more businesses is meaningful only if they operate in the same industry.
• Instead of looking at just a year-end snapshot of solvency or liquidity, analyze how these ratios trend over time to see whether the company’s financial position is improving or deteriorating. Also, pay close attention to any negative outliers to determine whether they are the result of a one-time event or signal a weakening of business fundamentals.
Takeaway
Assessing solvency and liquidity ratios over time gives businesses a clearer picture of their financial standing. Monitoring these ratios on a routine basis can also inform better strategies for maximizing profit or in times of crisis, for continuing business activities.
